Velocity of Money - Explained
What is the Velocity of Money?
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What is the Velocity of Money?
The velocity of money refers to the rate or pace at which there is an exchange of money. In other words, it measures how frequently there is movement of money between transactions. Also, it determines the usage of one unit of currency in a specific time frame. Talking in a laymans language, it acts as the rate or pace at which individuals shell money. It is ascertained by dividing gross national product of a nation with its total money supply. Velocity has a huge role to play when it comes to ascertaining the rate at which money is moving from one person to another. This enables investors in determining the economic strength of a nation, and also acts as a major element in calculating the inflation phase of an economy.
- Velocity of money is the rate that involves the exchange of money in an economy.
- As the velocity rate tends to be fluctuating, it gets hard to derive between inflation and the value of money.
How does the Velocity of Money Work?
If an economy displays a higher velocity of money as compared to others, it means that it will have higher inflation rate as well, assuming all things being constant. The velocity of money can be referred to as the turnover received from the supply of money. Economists consider using wide standards of measuring money supply: M1 and M2. As per the Federal Reserve, M1 is the aggregate amount of currency that the public has, and transaction deposits made at depository organizations. M2 is the sum of savings deposits, real money market mutual funds and time deposits.
Example of Velocity of Money
Lets consider an example of two persons: A and B having $100 each. A purchases a vehicle from B for $100. Now, B buys a house property worth $90 from A. B asks As assistance in instilling exclusive infrastructure to his new place, and pays $100 for his services. A who purchase the vehicle from B returns it back to him for an amount of $90. Considering all the money involved, we can see that they are able to make transactions of $400 even if they had $100 each in the initial stage. With the concept of velocity of money, it gets feasible to multiply the value of goods and services exchanged throughout.
Calculating the Velocity of Money
It is easy to calculate the velocity of money by using this formula: V = PQ/M Where, PQ is the nominal GDP of an economy that ascertains the goods and services bought V is the velocity of money M is the total, average amount of money in movement in the economy Velocity of the money and the economy Several economists have different perspectives regarding the velocity of money. Whether it signifies the economic growth, or more importantly, inflationary forces. The economists who follow the quantity theory of money say that variations in the supply of money can lead to adjustments in expectations, and thereby, velocity of money and inflation. For instance, if there is a rise in the money supply in an economy, it will lead to a rise in prices as well as people will have more amounts of money for buying the usual quantum of goods and services available in the economy. If there is a fall in the money supply, it will lead to a decrease in prices. Critics of the velocity of money say that the economy experiences more fluctuations in terms of money velocity in the short-run. Additionally, as the prices dont change easily, it creates a weak and indirect relation between inflation and money supply. As per the data, the velocity of money as well as the relationship between money velocity and inflation are variable in nature. For instance, the velocity of M2 money stock performed 1.86x on an average having a high of 2.21x in 1997, and a low of 1.66x in 1964. This stats was covered from the year 1959 to 2007. However, the money velocity has started declining significantly since 2007. It was a result of Federal Reserve immensely broadening its financial statements so as to control the global crisis and deflation related pressures. As per the first quarter in the year 2016, M2 velocity was 1.46x only, just a bit more than 1.15x that was marked the lowest during the Great Depression. In the last 20 years, the correlation between inflation and M2 in the U.S. is only 0.3. Also, during the 1990s, there were times when this correlation value was in negatives, that is exactly the opposite result to what economists stated in their theories.
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